The difference between paying 20% tax on your investment profits versus 37% often comes down to one decision: how you structure your role in a partnership. General partners and limited partners face completely different tax rules, liability exposure, and income classifications—even when they’re invested in the exact same deal.
This guide breaks down how LP and GP structures actually work for tax purposes, from pass-through taxation and carried interest treatment to state filing obligations and common mistakes that erode your returns—an issue we routinely help solve as a Fractional CFO for Investment Companies.
What is an LP vs GP investment structure
The GP/LP structure delivers tax efficiency through pass-through taxation, which means profits flow directly to partners rather than being taxed at the entity level first. This setup allows flexible profit allocation, with income typically taxed at individual partner rates—often at favorable capital gains rates for the general partner’s carried interest. Limited partners contribute capital and enjoy liability protection, while general partners manage the investments and earn fees plus a share of profits.
So why does the difference between limited partner and general partner matter for your tax situation? Because the role you play determines how your income gets classified, what tax rates apply, and how much personal risk you take on. The partnership agreement spells out exactly how profits and losses get divided, and those allocation rules directly affect everyone’s tax bill.
Definition of a general partner
A general partner is the active manager who runs the show. The GP makes investment decisions, handles operations, and takes on unlimited personal liability for the partnership’s debts and obligations.
GPs earn money two ways. First, they collect management fees—typically 1-2% of assets under management each year. Second, they receive carried interest, which is their share of investment profits (usually around 20%) after limited partners get their preferred return. In real estate deals, you’ll often hear carried interest called “promote.”
Definition of a limited partner
A limited partner is a passive investor who puts up capital but stays out of management decisions. In exchange for this hands-off approach, LPs get limited liability—meaning they can only lose what they invested, nothing more.
LPs provide most of the money in a typical fund, often 90% or more of total capital. Their returns come from their allocable share of partnership profits, distributed according to whatever the partnership agreement specifies.
Why this structure dominates private equity and real estate
The general limited partnership model became standard in PE fund structures and real estate limited partnerships because it gives everyone what they want. People with expertise (GPs) get control and upside. People with capital (LPs) get professional management and liability protection.
The structure also cleanly separates roles. GPs bring deal-making skills and operational know-how. LPs bring money and patience. And both sides benefit from pass-through taxation, which we’ll dig into next.
How pass-through taxation works for general and limited partners
Unlike corporations, partnerships don’t pay taxes at the entity level. All income, deductions, gains, and losses “pass through” to individual partners, who then report everything on their personal tax returns.
This single layer of taxation eliminates the double taxation problem that hits C-corporations. With a C-corp, profits get taxed once at the corporate level, then again when distributed as dividends to shareholders. Partnerships skip that first layer entirely.
Understanding K-1 forms and partner tax reporting
Every year, partnerships send each partner a Schedule K-1. This form reports your allocable share of the partnership’s income, deductions, credits, and other tax items for that year.
Your K-1 becomes the foundation for reporting partnership income on your personal return. The character of income—whether it’s ordinary income, capital gains, or something else—flows through exactly as the partnership earned it. If the partnership sold a long-term asset for a gain, your share shows up as long-term capital gain on your K-1.
How partnership structures avoid double taxation
Here’s a simple comparison. A C-corporation earns $100,000 in profit and pays roughly $21,000 in corporate tax, leaving $79,000. When that money gets distributed as dividends, shareholders pay another 15-20% in taxes on what they receive.
A partnership earning the same $100,000 pays zero entity-level tax. Partners pay tax only once, on their individual returns. Over a 10-year investment horizon, this difference compounds into real money.
How taxes differ for limited partners and general partners
The tax treatment you receive depends heavily on which role you play. GPs and LPs face different rules around income classification, self-employment taxes, and loss deductions.
| Factor | General Partner | Limited Partner |
|---|---|---|
| Primary income types | Management fees, carried interest | Distributions, allocations |
| Income classification | Often ordinary income | Often passive income |
| Self-employment tax | May apply to fees | Generally does not apply |
| Loss deduction limits | Active participation rules | Passive activity loss limits |
Tax treatment of LP distributions and allocations
LPs receive their share of partnership profits based on allocation percentages spelled out in the partnership agreement. How those profits get taxed depends on the underlying income type.
If the partnership sold an asset held for more than a year, your share of that gain is long-term capital gains. If the partnership earned interest income, your share is ordinary income. The character passes through intact—the partnership doesn’t change it.
Tax treatment of GP fees, carry, and distributions
Management fees get taxed as ordinary income at rates up to 37% at the federal level. These fees may also trigger self-employment taxes, adding another 2.9-3.8% on top.
Carried interest receives more favorable treatment when structured properly. If the underlying investments are held for more than three years, carried interest qualifies for long-term capital gains rates—maxing out at 20% plus the 3.8% net investment income tax. That’s a significant difference from ordinary income rates.
Active vs passive income classification rules
The IRS classifies GP income as active because GPs materially participate in the business. LP income is typically passive because LPs don’t participate in management.
This distinction matters most for loss deductions. Passive losses can only offset passive income, while active losses have more flexibility. If you’re an LP with passive losses from one investment, you can use those losses to offset passive gains from another partnership—but not your W-2 wages.
How carried interest and management fees are taxed
These two income streams represent the primary ways GPs get paid, yet they receive dramatically different tax treatment. Understanding the difference helps explain why fund structures look the way they do.
Carried interest and capital gains treatment
Carried interest is the GP’s share of profits—typically 20%—earned after LPs receive their preferred return. When held for the required period, carried interest qualifies for long-term capital gains rates rather than ordinary income rates.
The three-year holding period requirement, introduced in 2017, means GPs need to hold investments for at least three years to receive capital gains treatment on their carry. Shorter holding periods result in ordinary income treatment, which roughly doubles the tax rate.
Management fee taxation for general partners
Management fees are straightforward: they’re ordinary income, taxed at your marginal rate. For high-earning GPs, that means federal rates up to 37% plus applicable state taxes.
These fees are also subject to self-employment tax. This explains why many GPs prefer compensation through carried interest over higher management fees when they have the choice.
Fee waiver strategies for tax efficiency
Some GPs waive a portion of their management fees in exchange for additional partnership interest. This approach converts what would be ordinary income into potential capital gains down the road.
However, the IRS watches these arrangements closely. The waiver has to happen before services are rendered, and there has to be genuine risk that the GP might not receive the converted amount. Paper-only arrangements don’t pass muster.
Liability and financial risk differences between GPs and LPs
Tax efficiency isn’t the only factor when choosing between GP and LP roles. Liability exposure differs dramatically between the two positions.
Unlimited liability exposure for general partners
GPs face unlimited personal liability for partnership debts and obligations. If the partnership can’t pay its creditors, those creditors can pursue the GP’s personal assets—home, savings, everything.
This is why most GPs operate through an LLC or corporation. The GP entity—not the individual person—serves as general partner, providing a liability shield while maintaining the tax benefits of the partnership structure. Many investment teams also formalize processes and reporting to reduce operational risk—see how internal controls for investment companies can protect both returns and governance.
Limited liability protections for limited partners
LPs risk only their invested capital. Creditors cannot pursue an LP’s personal assets beyond what they’ve already contributed to the partnership.
This protection comes with a catch, though. LPs have to remain passive. If an LP participates in management decisions, they risk losing their limited liability status and being treated as a general partner for liability purposes.
State tax considerations for real estate limited partnerships and other LP structures
Partnerships operating across multiple states create tax complexity that can chip away at your returns if not managed properly. Real estate limited partnerships are particularly affected since the property’s location—not the partners’ residences—typically determines which state taxes the income.
- Nexus and filing obligations: Partners may owe taxes in every state where the partnership operates, not just their home state
- Withholding requirements: Many states require partnerships to withhold taxes on income allocated to nonresident partners
- Carried interest treatment: Some states don’t follow federal treatment of carried interest and tax it as ordinary income instead
How to choose between GP and LP roles for optimal tax efficiency
The right choice depends on your goals, expertise, and risk tolerance. Neither role is universally better—each fits different situations.
When being a general partner makes tax sense
The GP role fits when you have expertise to add value through active management and want access to carried interest. Despite ordinary income treatment on management fees, the potential for capital gains on carry can be substantial over time.
GPs also benefit from control. You decide when to buy, when to sell, and how to structure deals—all of which affect tax outcomes.
When being a limited partner is the better fit
The LP role suits investors who want exposure to alternative investments without the time commitment or liability of active management. Passive income treatment and limited liability provide a cleaner, more predictable tax situation.
LPs also avoid self-employment taxes entirely on their partnership income, which can represent meaningful savings compared to GP fee income.
Common tax mistakes in LP and GP structures
Even well-structured partnerships can create tax problems when partners don’t understand the rules or get sloppy with documentation.
- Misclassifying income: Treating passive income as active (or vice versa) triggers IRS scrutiny and potential penalties
- Ignoring state filing requirements: Multi-state partnerships create unexpected tax obligations that catch partners off guard at filing time
- Poor documentation: Partnership agreements need to clearly define allocations with “substantial economic effect” to withstand IRS review
- Missing holding period requirements: Selling carried interest before three years converts capital gains to ordinary income
Many of these mistakes can be caught early with disciplined review processes, including financial due diligence for investment firms that stress-tests allocations, compliance exposure, and the real after-tax economics.
Building tax-efficient investment partnerships that support long-term growth
Proper structure from the start saves money and complexity later. The difference between a well-designed partnership and a poorly structured one can mean hundreds of thousands of dollars in unnecessary taxes over the life of an investment.
This is where strategic financial guidance becomes valuable. At Bennett Financials, we help growth-focused business owners navigate LP and GP structures with proactive tax planning and CFO-level insight—turning tax savings into fuel for growth rather than just a line item on your return through strategic fractional CFO support.
Talk to an expert about structuring your investments for maximum tax efficiency.
